Chapter 15

Capital Structure Decisions

Topics in Chapter

Overview and preview of capital

structure effects
Business versus financial risk
The impact of debt on returns
Capital structure theory, evidence,
and implications for managers
Example: Choosing the optimal
structure
2

Determinants of Intrinsic Value:

The Capital Structure Choice
Net operating
profit after taxes

Required investments
in operating capital

Free cash flow

=
(FCF)

Value =

FCF1
(1 + WACC)1

FCF2
+
(1 + WACC)2

Weighted average
cost of capital
(WACC)
Market interest rates
Market risk aversion

FCF
+ +
(1 +
WACC)

Firms
Firms
debt/equity
debt/equity
mix
mix

Cost of debt
Cost of equity

Firms business risk

3

Basic Definitions

V = value of firm
FCF = free cash flow
WACC = weighted average cost of
capital
rs and rd are costs of stock and debt
ws and wd are percentages of the firm
that are financed with stock and debt.
4

How can capital structure

affect value?

t=
1

FCFt
(1 +
t
WACC)

WACC= wd (1-T) rd + wsrs

5

A Preview of Capital
Structure Effects

The impact of capital structure on

value depends upon the effect of
debt on:

WACC
FCF

(Continued)
6

The Effect of Additional

Debt on WACC

Debtholders have a prior claim on cash

flows relative to stockholders.

Debtholders fixed claim increases risk of

stockholders residual claim.
Cost of stock, rs, goes up.

Firms can deduct interest expenses.

Reduces the taxes paid

Frees up more cash for payments to investors
Reduces after-tax cost of debt
(Continued)
7

The Effect on WACC

(Continued)

Debt increases risk of bankruptcy

Causes pre-tax cost of debt, rd, to

increase

Adding debt increase percent of firm

financed with low-cost debt (w d) and
decreases percent financed with
high-cost equity (ws)

Net effect on WACC = uncertain.

(Continued)
8

The Effect of Additional

Debt on FCF

Additional debt increases the

probability of bankruptcy.

Direct costs: Legal fees, fire sales,

etc.
Indirect costs: Lost customers,
reduction in productivity of managers
and line workers, reduction in credit
(i.e., accounts payable) offered by
suppliers
(Continued)
9

Impact of indirect costs

NOPAT goes down due to lost

customers and drop in productivity
Investment in capital goes up due to
increase in net operating working
capital (accounts payable goes down
as suppliers tighten credit).
(Continued)
10

Additional debt can affect the behavior

of managers.

Reductions in agency costs: debt precommits, or bonds, free cash flow for use
in making interest payments. Thus,
managers are less likely to waste FCF on
perquisites or non-value adding acquisitions.
Increases in agency costs: debt can make
managers too risk-averse, causing
underinvestment in risky but positive NPV
projects.
(Continued)
11

Asymmetric Information
and Signaling

Managers know the firms future

prospects better than investors.
Managers would not issue additional
equity if they thought the current stock
price was less than the true value of the
stock (given their inside information).
Hence, investors often perceive an
additional issuance of stock as a
negative signal, and the stock price falls.
12

Business Risk: Uncertainty

in EBIT, NOPAT, and ROIC

Uncertainty about demand (unit

sales).
Uncertainty about output prices.
Uncertainty about input costs.
Product and other types of liability.
Degree of operating leverage
(DOL).
13

What is operating leverage, and

how does it affect a firms
business risk?

Operating leverage is the change

in EBIT caused by a change in
quantity sold.
The higher the proportion of fixed
costs relative to variable costs, the
greater the operating leverage.
(More...)
14

Higher operating leverage leads to

more business risk: small sales
decline causes a larger EBIT decline.
Rev.

Rev.
$
TC

} EBIT
TC

F
QBE

Sales

QBE

Sales
(More...)
15

Operating Breakeven

Q is quantity sold, F is fixed cost, V is

variable cost, TC is total cost, and P is
price per unit.
Operating breakeven = QBE

QBE = F / (P V)

Example: F=$200, P=$15, and V=$10:

QBE = $200 / ($15 $10) = 40.

(More...)
16

Business Risk versus

Financial Risk

Business risk:

Uncertainty in future EBIT, NOPAT, and ROIC.

Depends on business factors such as
competition, operating leverage, etc.

Financial risk:

Additional business risk concentrated on

common stockholders when financial leverage
is used.
Depends on the amount of debt and preferred
stock financing.
17

Consider Two Hypothetical

Firms Identical Except for
Debt
Capital
Debt

Firm U
$20,000
$0

Equity
Tax rate
EBIT
NOPAT
ROIC

$20,000
40%
$3,000
$1,800
9%

Firm L
$20,000
$10,000 (12%
rate)
$10,000
40%
$3,000
$1,800
9%

18

Impact of Leverage on
Returns
EBIT
Interest
EBT
Taxes (40%)
NI
ROIC
ROE
(NI/Equity)

Firm U
$3,000
0
$3,000
1 ,200
$1,800

Firm L
$3,000
1,200
$1,800
720
$1,080

9.0%
9.0%

9.0%
10.8%
19

Why does leveraging

increase return?

More cash goes to investors of Firm L.

Total dollars paid to investors:

Taxes paid:

U: NI = $1,800.
L: NI + Int = $1,080 + $1,200 = $2,280.
U: $1,200
L:
$720.

In Firm L, fewer dollars are tied up in

equity.
20

Impact of Leverage on
Returns if EBIT Falls
EBIT
Interest

Firm U
$2,000
0

Firm L
$2,000
1,200

EBT
Taxes (40%)
NI
ROIC
ROE

$2,000
800
$1,200
6.0%
6.0%

$800
320
$480
6.0%
4.8%

21

Capital Structure Theory

MM theory

Zero taxes
Corporate taxes
Corporate and personal taxes

Trade-off theory
Signaling theory
Pecking order
Debt financing as a managerial constraint
Windows of opportunity
22

MM Theory: Zero Taxes

Firm U

Firm L

$3,000

$3,000

1,200

NI

$3,000

$1,800

CF to
shareholder

$3,000

$1,800

$1,200

$3,000

23
$3,000

EBIT
Interest

CF to
debtholder
Total CF

MM Results: Zero Taxes

MM assume: (1) no transactions costs; (2) no

restrictions or costs to short sales; and (3)
individuals can borrow at the same rate as
corporations.
MM prove that if the total CF to investors of Firm
U and Firm L are equal, then arbitrage is possible
unless the total values of Firm U and Firm L are
equal:

VL = V U.

Because FCF and values of firms L and U are

equal, their WACCs are equal.
Therefore, capital structure is irrelevant.
24

MM Theory: Corporate
Taxes

Corporate tax laws allow interest to

be deducted, which reduces taxes
paid by levered firms.
Therefore, more CF goes to
investors and less to taxes when
leverage is used.
In other words, the debt shields
some of the firms CF from taxes.
25

MM Result: Corporate
Taxes

MM show that the total CF to Firm Ls

investors is equal to the total CF to Firm
Us investor plus an additional amount due
to interest deductibility:

What is value of these cash flows?

CFL = CFU + rdDT.

Value of CFU = VU
MM show that the value of rdDT = TD
Therefore, VL = VU + TD.

If T=40%, then every dollar of debt adds

40 cents of extra value to firm.
26

MM relationship between value and

debt when corporate taxes are
considered.
Value of Firm, V
VL
TD

VU
Debt

Under MM with corporate taxes, the firms value

increases continuously as more and more debt is used.
27

Millers Theory: Corporate

and Personal Taxes

Personal taxes lessen the advantage

of corporate debt:

Corporate taxes favor debt financing

since corporations can deduct interest
expenses.
Personal taxes favor equity financing,
since no gain is reported until stock is
sold, and long-term gains are taxed at
a lower rate.
28

Millers Model with

Corporate and Personal
Taxes
(1 - Tc)(1 - Ts)
VL = VU + 1
(1 - Td)

Tc = corporate tax rate.

Td = personal tax rate on debt
income.
Ts = personal tax rate on stock
income.

29

Tc = 40%, Td = 30%,
and Ts = 12%.
(1 - 0.40)(1 - 0.12)
VL = VU + 1
(1 - 0.30)
= VU + (1 - 0.75)D

= VU + 0.25D.
Value rises with debt; each $1 increase
in debt raises Ls value by $0.25.
30

Conclusions with Personal

Taxes

Use of debt financing remains

advantageous, but benefits are less
than under only corporate taxes.
Firms should still use 100% debt.
Note: However, Miller argued that in
equilibrium, the tax rates of
marginal investors would adjust until
there was no advantage to debt.
31

Trade-off Theory

MM theory ignores bankruptcy (financial

distress) costs, which increase as more
leverage is used.
At low leverage levels, tax benefits
outweigh bankruptcy costs.
At high levels, bankruptcy costs
outweigh tax benefits.
An optimal capital structure exists that
balances these costs and benefits.
32

Tax Shield vs. Cost of Financial

Distress
Tax Shield

Value of Firm, V
VL

VU
0

Debt

Distress Costs
33

Signaling Theory

MM assumed that investors and

managers have the same information.
But, managers often have better
information. Thus, they would:

Sell stock if stock is overvalued.

Sell bonds if stock is undervalued.

Investors understand this, so view new

stock sales as a negative signal.
Implications for managers?
34

Pecking Order Theory

Firms use internally generated funds

first, because there are no flotation
costs or negative signals.
If more funds are needed, firms then
issue debt because it has lower flotation
costs than equity and not negative
signals.
If more funds are needed, firms then
issue equity.
35

Debt Financing and

Agency Costs

One agency problem is that

managers can use corporate funds
for non-value maximizing purposes.
The use of financial leverage:

Bonds free cash flow.

Forces discipline on managers to
avoid perks and non-value adding
acquisitions.

(More...)
36

A second agency problem is the

potential for underinvestment.

Debt increases risk of financial

distress.
Therefore, managers may avoid risky
projects even if they have positive
NPVs.

37

Investment Opportunity Set

and Reserve Borrowing
Capacity

Firms with many investment

opportunities should maintain
reserve borrowing capacity,
especially if they have problems
with asymmetric information
(which would cause equity issues
to be costly).
38

Windows of Opportunity

Managers try to time the market when

issuing securities.
They issue equity when the market is
high and after big stock price run ups.
They issue debt when the stock market is
low and when interest rates are low.
The issue short-term debt when the term
structure is upward sloping and long-term
debt when it is relatively flat.
39

Empirical Evidence

Tax benefits are important $1 debt

adds about $0.10 to value.
Bankruptcies are costly costs can
be up to 10% to 20% of firm value.
Firms dont make quick corrections
when stock price changes cause
their debt ratios to change doesnt
support trade-off model.
40

Empirical Evidence
(Continued)

After big stock price run ups, debt ratio

falls, but firms tend to issue equity
instead of debt.

Inconsistent with trade-off model.

Inconsistent with pecking order.
Consistent with windows of opportunity.

Many firms, especially those with growth

options and asymmetric information
problems, tend to maintain excess
borrowing capacity.
41

Implications for Managers

Take advantage of tax benefits by

issuing debt, especially if the firm
has:

High tax rate

Stable sales
Low operating leverage

42

Implications for Managers

(Continued)

Avoid financial distress costs by

maintaining excess borrowing
capacity, especially if the firm has:

Volatile sales
High operating leverage
Many potential investment opportunities
Special purpose assets (instead of general
purpose assets that make good collateral)
43

Implications for Managers

(Continued)

If manager has asymmetric

information regarding firms future
prospects, then avoid issuing equity
if actual prospects are better than
the market perceives.
Always consider the impact of
capital structure choices on lenders
and rating agencies attitudes
44

Choosing the Optimal

Capital Structure: Example

b = 1.0; rRF = 6%; RPM = 6%.

Cost of equity using CAPM:

Currently has no debt: wd = 0%.

rs = rRF +b (RPM)= 6% + 1(6%) = 12%

WACC = rs = 12%.

Tax rate is T = 40%.

45

Current Value of
Operations

Expected FCF = $30 million.

Firm expects zero growth: g = 0.
Vop = [FCF(1+g)]/(WACC g)
Vop = [$30(1+0)]/(0.12 0)
Vop = $250 million.

46

Other Data for Valuation

Analysis

Company has no ST investments.

Company has no preferred stock.
10,000,000 shares outstanding

47

Current Valuation Analysis

Vop

$250

+ ST Inv.
VTotal

0
$250

Debt
S

0
$250

n
P

10
$25.00
48

Investment bankers provided

estimates of rd for different capital
structures.
wd

0%

20%

30%

40%

50%

rd

0.0%

8.0%

8.5%

10.0%

12.0%

If company recapitalizes, it will use proceeds

from debt issuance to repurchase stock.

49

The Cost of Equity at Different

Levels of Debt: Hamadas
Formula

MM theory implies that beta

changes with leverage.
bU is the beta of a firm when it has
no debt (the unlevered beta)
b = bU [1 + (1 - T)(wd/ws)]

50

The Cost of Equity for wd =

20%

Use Hamadas equation to find beta:

b = bU [1 + (1 - T)(wd/ws)]
= 1.0 [1 + (1-0.4) (20% / 80%) ]
= 1.15
Use CAPM to find the cost of equity:
rs= rRF + bL (RPM)
= 6% + 1.15 (6%) = 12.9%

51

The WACC for wd = 20%

WACC = wd (1-T) rd + wce rs

WACC = 0.2 (1 0.4) (8%) + 0.8

(12.9%)
WACC = 11.28%

Repeat this for all capital

structures under consideration.
52

Beta, rs, and WACC

wd

0%

20%

30%

40%

50%

rd

0.0%

8.0%

8.5%

10.0%

12.0%

ws

100%

80%

70%

60%

50%

1.000

1.150

1.257

1.400

1.600

rs

12.00%

12.90%

13.54%

14.40%

15.60%

WACC

12.00%

11.28% 11.01%

11.04%

11.40%

The WACC is minimized for wd = 30%. This is the

optimal capital structure.
53

Corporate Value for wd =

20%

Vop = [FCF(1+g)]/(WACC g)
Vop = [$30(1+0)]/(0.1128 0)
Vop = $265.96 million.

Debt = DNew = wd Vop

Debt = 0.20(265.96) = $53.19 million.

Equity = S = ws Vop
Equity = 0.80(265.96) = $212.77 million.
54

Value of Operations, Debt,

and Equity
wd

0%

20%

30%

40%

50%

rd

0.0%

8.0%

8.5%

10.0%

12.0%

ws

100%

80%

70%

60%

50%

1.000

1.150

1.257

1.400

1.600

rs

12.00%

12.90%

13.54%

14.40%

15.60%

WACC

12.00%

11.28%

11.01%

11.04%

11.40%

Vop
D
S

$250.00 $265.96
$0.00

$53.19

$272.4 $271.74 $263.16

8
$81.74

$108.70 $131.58

$250.00 $212.77 $190.74 $163.04 $131.58

Value of operations is maximized at wd = 30%.

55

Anatomy of a Recap:
Before Issuing Debt

Before Debt
Vop
+ ST Inv.
VTotal
Debt

$250
0
$250
0

$250

10

$25.00

Total
shareholder
wealth: S +

56

Issue Debt (wd = 20%),

But Before Repurchase

WACC decreases to 11.28%.

Vop increases to $265.9574.
Firm temporarily has short-term
investments of $53.1915 (until it
uses these funds to repurchase
stock).
Debt is now $53.1915.
57

Anatomy of a Recap: After

Debt, but Before
Repurchase
After Debt,

Before Debt
Vop
+ ST Inv.
VTotal
Debt

$250
0
$250
0

Before Rep.
$265.96
53.19
$319.15
53.19

$250

$265.96

10

10

$25.00

$26.60

Total
shareholder

58

After Issuing Debt, Before

Repurchasing Stock

Stock price increases from $25.00

to $26.60.
Wealth of shareholders (due to
ownership of equity) increases
from $250 million to $265.96
million.

59

The Repurchase: No Effect

on Stock Price

The announcement of an intended repurchase

might send a signal that affects stock price,
and the previous change in capital structure
affects stock price, but the repurchase itself
has no impact on stock price.

If investors thought that the repurchase would

increase the stock price, they would all purchase
stock the day before, which would drive up its price.
If investors thought that the repurchase would
decrease the stock price, they would all sell short the
stock the day before, which would drive down the
stock price.
60

Remaining Number of
Shares After Repurchase

DOld is amount of debt the firm initially has,

DNew is amount after issuing new debt.
If all new debt is used to repurchase
shares, then total dollars used equals

(DNew DOld) = ($53.19 - $0) = $53.19.

nPrior is number of shares before

repurchase, nPost is number after. Total
shares remaining:

nPost = nPrior (DNew DOld)/P

nPost = 10 ($53.19/$26.60)
nPost = 10 2 = 8 million.

(Ignore rounding differences; see Ch15 Mini Case.xls for actual calculations).

61

Anatomy of a Recap: After

Repurchase

Before Debt
Vop
+ ST Inv.
VTotal
Debt

$250
0
$250
0

After Debt,
Before Rep.
$265.96
53.19
$319.15
53.19

After Rep.
$265.96
0
$265.96
53.19

$250

$265.96

$212.77

10

10

$25.00

$26.60

$26.60

Total
shareholder

62

Key Points

ST investments fall because they are

used to repurchase stock.
Stock price is unchanged.
Value of equity falls from $265.96 to
$212.77 because firm no longer owns
the ST investments.
Wealth of shareholders remains at
$265.96 because shareholders now
directly own the funds that were held by
firm in ST investments.
63

Intrinsic Stock Price

Maximized at Optimal
wCapital
0% Structure
20%
30%
40%
d

50%

rd

0.0%

8.0%

8.5%

10.0%

12.0%

ws

100%

80%

70%

60%

50%

1.000

1.150

1.257

1.400

1.600

rs

12.00%

12.90%

13.54%

14.40%

15.60%

WACC

12.00%

11.28% 11.01%

11.04%

11.40%

Vop
D
S
n
P

$250.00 $265.96
$0.00

$53.19

$272.4 $271.74 $263.16

8
$81.74

$108.70 $131.58

$250.00 $212.77 $190.74 $163.04 $131.58

10
$25.00

8
$26.60

7
$27.25

6
$27.17

5
$26.32

64

Shortcuts

The corporate valuation approach

will always give the correct
answer, but there are some
shortcuts for finding S, P, and n.
Shortcuts on next slides.

65

Calculating S, the Value of

Equity after the Recap

S = (1 wd) Vop

At wd = 20%:

S = (1 0.20) $265.96
S = $212.77.

(Ignore rounding differences; see Ch15 Mini Case.xls for actual calculations).

66

Number of Shares after a

Repurchase, nPost

At wd = 20%:

nPost = nPrior(VopNewDNew)/(VopNewDOld)
nPost = 10($265.96 $53.19)/($265.96
$0)

nPost = 8

67

Calculating PPost, the

Stock Price after a Recap

At wd = 20%:

PPost = (VopNewDOld)/nPrior
nPost = ($265.96 $0)/10
nPost = $26.60

68

Optimal Capital Structure

wd = 30% gives:

Highest corporate value

Lowest WACC
Highest stock price per share

But wd = 40% is close. Optimal range

is pretty flat.
69